BoE paper outlines DSGE model of financial and real frictions

Building financial and real economy frictions into a dynamic stochastic general equilibrium model can generate important insights for the macroeconomy, according to a working paper published by the Bank of England.

Authors Stephen Millard, Alexandra Varadi and Eran Yashiv calibrate a DSGE model of the US economy with both financial frictions and labour market frictions. The model also contains price frictions and habits in consumption.

The model requires firms to borrow from the banking sector to make investments and to pay their workers, thereby linking financial conditions to the real economy.

The authors find the interaction of financial and real frictions matters for the behaviour of variables in the model. However, for some key shocks such as productivity and monetary policy, the labour market frictions are much more important.

“We find that the interactions of real frictions and financial frictions have important implications for the effects of financial shocks on the macroeconomy,” the authors say.